Lecture 06

UNIT 2 DEMAND ANALYSIS INTRODUCTION: UNIT 2 is basically on the demand analysis. This unit will give you detail idea about the meaning of demand and its determinants, supply and its determinants law of demand and supply, elasticity of demand and supply. It will give you an idea about the relationship between price and quantity demanded.

Lesson 6 Demand and its determinants

Learning outcomes After studying this unit, you should be able to: appreciate the significance of demand analysis specify a demand function, identifying the determinants classify various types of demand comprehend a long list demand concepts locate the sources of demand relate demand to the nature of market structure

INTRODUCTION Students why have you selected M.B.A. in your career? It is because M.B.A.’s have great demand in a job market. Thus demand is one of the most critical economic decision variables. Demand reflects the size and the pattern of market. Business activity is always market-determined. The manufacturers’ inducement to invest in a given line of production is limited by the size of market The demand for output and input; the demand for the firm and the industry; the demand by the consumer and stockiest; and similar other demand concepts become therefore, relevant for managerial decision analysis. Even if the firm pursues objectives alternative to profit-maximization, demand concepts still remain relevant. For example, suppose the firm is aiming at ‘customer service’ not profit. How can it ensure quantity and quality of service, without analyzing what the customer really wants? Or suppose, the firm is destined to discharge ‘social responsibility’ of business. Can this be done without evaluating social preferences? Tastes, preferences and choices are all concepts directly built into the economic concepts of ‘demand’. SIGNIFICANCE OF DEMAND ANALYSIS Demand is one of the crucial requirements for the functioning of any business enterprise its survival and growth. Demand analysis is of profound significance to management. Information on the size and type of demand helps management in planning its requirements of men, materials, machines, money and what have you. o For example, if the demand for a product is subject to temporary business recession, the firm may plan to pile up the stock of unsold

products. If the demand for a product shows a trend towards a substantial and sustained increase in the long run, the firm may plan to install additional plant and equipment to meet the demand on a permanent basis. If the demand for a firm’s product is falling, while its rival’s sale is increasing, the firm needs to plan its sales tactics; the firm may need to undertake some sales promotion activity like advertisement. If the firm’s supply of the product is unable to meet its existing demand, the firm may be required to revise its production plan and schedule; or the firm may have to review its purchase plan for inputs and the suppliers’ response to input requirements by the firm. In the same way, larger the demand for a firm’s product, the higher is the price the firm can change. o The common theme underlying these examples is that the whole range of planning by the firm–production planning, inventory planning, cost budgeting, purchase plan, market research, pricing decision, advertisement budget, profit planning etc. – call for an analysis of demand. In fact, demand analysis is one area of economics that has been used most extensively by business. The decision which management makes with respect to any functional area, always hinges on an analysis of demand. Demand analysis seeks to identify and measure the forces that determine sales; it reflects the market conditions for the firm’s product. Once the demand analysis is done, the alternative ways of creating, controlling or managing demand can be inferred.

Activity 1 Briefly answer the following questions : a) Why is a person interested in knowing the demand for the shares he has purchased? ……………………………………………………………………………………………… ……………………………………………………………………………………………… …………………………………… b) Why should the Food Corporation of India be concerned about the demand for foodgrains to be released for public distribution system?

c) Why does the Maruti Udyog Ltd. Ask one of its officers to estimate the demand fro Premier 118 NE in 1990?

d) Why does a bank analyse the seasonal demand for credit?

. CONCEPT OF DEMAND As we have indicated earlier, ‘demand’ is a technical concept from Economics. Demand for product implies: a) desires to acquire it, b) willingness to pay for it, and c) Ability to pay for it. All three must be checked to identify and establish demand. For example : A poor man’s desires to stay in a five-star hotel room and his willingness to pay rent for that room is not ‘demand’, because he lacks the necessary purchasing power; so it is merely his wishful thinking. Similarly, a miser’s desire for and his ability to pay for a car is not ‘demand’, because he does not have the necessary willingness to pay for a car. One may also come across a well-established person who processes both the willingness and the ability to pay for higher education. But he has really no desire to have it, he pays the fees for a regular cause, and eventually does not attend his classes. Thus, in an economics sense, he does not have a ‘demand’ for higher education degree/diploma. It should also be noted that the demand for a product–-a commodity or a service–has no meaning unless it is stated with specific reference to the time, its price, price of is related goods, consumers’ income and tastes etc. This is because demand, as is used in Economics, varies with fluctuations in these factors. To say that demand for an Atlas cycle in India is 60,000 is not meaningful unless it is stated in terms of the year, say 1983 when an Atlas cycle’s price was around Rs. 800, competing cycle’s prices were around the same, a scooter’s prices was around Rs. 5,000. In 1984, the demand for an Atlas cycle could be different if any of the above factors happened to be different. For example, instead of domestic (Indian), market, one may be interested in foreign (abroad) market as well. Naturally the demand estimate will be different. Furthermore, it should be noted that a commodity is defined with reference to its particular quality/brand; if its quality/brand changes, it can be deemed as another commodity. To sum up, we can say that the demand for a product is the desire for that product backed by willingness as well as ability to pay for it. It is always defined with reference to a particular time, place, price and given values of other variables on which it depends.

Activity 2 a) Construct some specific examples showing that despite having a ‘desire’, a person may not have i) ‘willingness to pay’ : ii) ‘ability to pay’ : b) What do you mean by : i) A household’s demand for a T.V. set:

ii) A firm’s demand for labour :

iii) Our Government’s demand for defence equipment:

Demand Function and Demand Curve Demand function is a comprehensive formulation which specifies the factors that influence the demand for the product. What can be those factors which affect the demand? For example, Dx = D (Px, Py, Pz, B, W, A, E, T, U) Here Dx, stands for demand for item x (say, a car) Px, its own price (of the car) Py, the price of its substitutes (other brands/models) Pz, the price of its complements (like petrol) B, the income (budget) of the purchaser (user/consumer) W, the wealth of the purchaser

A, the advertisement for the product (car) E, the price expectation of the user T, taste or preferences of user U, all other factors. Briefly we can state the impact of these determinants, as we observe in normal circumstances: i) Demand for X is inversely related to its own price. As price rises, the demand tends to fall and vice versa. ii) The demand for X is also influenced by its related price—of goods related to X. For example, if Y is a substitute of X, then as the price of Y goes up, the demand for X also tends to increase, and vice versa. In the same way, if Z goes up and, therefore, the demand for X tends to go up. iii) The demand for X is also sensitive to price expectation of the consumer; but here, much would depend on the psychology of the consumer; there may not be any definite relation. This is speculative demand. When the price of a share is expected to go up, some people may buy more of it in their attempt to make future gains; others may buy less of it, rather may dispose it off, to make some immediate gain. Thus the price expectation effect on demand is not certain. iv) The income (budget position) of the consumer is another important influence on demand. As income (real purchasing capacity) goes up, people buy more of ‘normal goods’ and less of ‘inferior goods’. Thus income effect on demand may be positive as well as negative. The demand of a person (or a household) may be influenced not only by the level of his own absolute income, but also by relative income—his income relative to his neighbour’s income and his purchase pattern. Thus a household may demand a new set of furniture, because his neighbour has recently renovated his old set of furniture. This is called ‘demonstration effect’. v) Past income or accumulated savings out of that income and expected future income, its discounted value along with the present income—permanent and transitory—all together determine the nominal stock of wealth of a person. To this, you may also add his current stock of assets and other forms of physical capital; finally adjust this to price level. The real wealth of the consumer, thus computed, will have an influence on his demand. A person may pool all his resources to construct the ground floor of his house. If he has access to some additional resources, he may then construct the first floor rather than buying a flat. Similarly one who has a colour TV (rather than a black-and-white one) may demand a V.C.R./V.C.P. This is regarded as the real wealth effect on demand.

vi) Advertisement also affects demand. It is observed that the sales revenue of a firm increases in response to advertisement up to a point. This is promotional effect on demand (sales). Thus vii) Tastes, preferences, and habits of individuals have a decisive influence on their pattern of demand. Sometimes, even social pressure—customs, traditions and conventions exercise a strong influence on demand. These sociopsychological determinants of demand often defy any theoretical construction; these are non-economic and non-market factors—highly indeterminate. In some cases, the individual reveal his choice (demand) preferences; in some cases, his choice may be strongly ordered. We will revisit these concepts in the next unit. You may now note that there are various determinants of demand, which may be explicitly taken care of in the form of a demand function. By contrast, a demand curve only considers the price-demand relation, other things (factors) remaining the same. This relationship can be illustrated in the form of a table called demand schedule and the data from the table may be given a diagrammatic representation in the form of a curve. In other words, a generalized demand function is a multivariate function whereas the demand curve is a single variable demand function. Dx = D(Px) In the slope—intercept from, the demand curve which may be stated as Dx = α + β Px, where α is the intercept term and β the slope which is negative because of inverse relationship between Dx and Px. Suppose, β = (-) 0.5, and α = 10 Then the demand function is : D=10-0.5P TYPES OF DEMAND Till now we have that may specify demand in the form of a function. Much of this specification and its form depends on the nature of demand itself – its type and determinants. From this standpoint, we can talk about a few other distinct concepts of demand: i) Direct and Derived Demands Direct demand refers to demand for goods meant for final consumption; it is the demand for consumers’ goods like food items, readymade garments and houses. By contrast, derived demand refers to demand for goods which are needed for further production; it is the demand for producers’ goods like industrial raw

materials, machine tools and equipments. Thus the demand for an input or what is called a factor of production is a derived demand; its demand depends on the demand for output where the input enters. In fact, the quantity of demand for the final output as well as the degree of substituability/complementarty between inputs would determine the derived demand for a given input. For example, the demand for gas in a fertilizer plant depends on the amount of fertilizer to be produced and substitutability between gas and coal as the basis for fertilizer production. However, the direct demand for a product is not contingent upon the demand for other products. ii) Domestic and Industrial Demands The example of the refrigerator can be restated to distinguish between the demand for domestic consumption and the demand for industrial use. In case of certain industrial raw materials which are also used for domestic purpose, this distinction is very meaningful. For example, coal has both domestic and industrial demand, and the distinction is important from the standpoint of pricing and distribution of coal. iii) Autonomous and Induced Demand When the demand for a product is tied to the purchase of some parent product, its demand is called induced or derived. For example, the demand for cement is induced by (derived from) the demand for housing. As stated above, the demand for all producers’ goods is derived or induced. In addition, even in the realm of consumers’ goods, we may think of induced demand. Consider the complementary items like tea and sugar, bread and butter etc. The demand for butter (sugar) may be induced by the purchase of bread (tea). Autonomous demand, on the other hand, is not derived or induced. Unless a product is totally independent of the use of other products, it is difficult to talk about autonomous demand. In the present world of dependence, there is hardly any autonomous demand. Nobody today consumers just a single commodity; everybody consumes a bundle of commodities. Even then, all direct demand may be loosely called autonomous. iv) Perishable and Durable Goods’ Demands Both consumers’ goods and producers’ goods are further classified into perishable/non-durable/single-use goods and durable/non-perishable/repeateduse goods. The former refers to final output like bread or raw material like cement which can be used only once. The latter refers to items like shirt, car or a machine which can be used repeatedly. In other words, we can classify goods into several categories: single-use consumer goods, single-use producer goods, durable-use consumer goods and durable-use producer’s goods. This distinction is useful because durable products present more complicated problems of demand analysis than perishable products. Non-durable items are

meant for meeting immediate (current) demand, but durable items are designed to meet current as well as future demand as they are used over a period of time. So, when durable items are purchased, they are considered to be an addition to stock of assets or wealth. Because of continuous use, such assets like furniture or washing machine, suffer depreciation and thus call for replacement. Thus durable goods demand has two varieties – replacement of old products and expansion of total stock. Such demands fluctuate with business conditions, speculation and price expectations. Real wealth effect influences demand for consumer durables. v) New and Replacement Demands This distinction follows readily from the previous one. If the purchase or acquisition of an item is meant as an addition to stock, it is a new demand. If the purchase of an item is meant for maintaining the old stock of capital/asset, it is replacement demand. Such replacement expenditure is to overcome depreciation in the existing stock. Producers’ goods like machines. The demand for spare parts of a machine is replacement demand, but the demand for the latest model of a particular machine (say, the latest generation computer) is anew demand. In course of preventive maintenance and breakdown maintenance, the engineer and his crew often express their replacement demand, but when a new process or a new technique or anew product is to be introduced, there is always a new demand. You may now argue that replacement demand is induced by the quantity and quality of the existing stock, whereas the new demand is of an autonomous type. However, such a distinction is more of degree than of kind. For example, when demonstration effect operates, a new demand may also be an induced demand. You may buy a new VCR, because your neighbor has recently bought one. Yours is a new purchase, yet it is induced by your neighbor’s demonstration. vi) Final and Intermediate Demands This distinction is again based on the type of goods- final or intermediate. The demand for semi-finished products, industrial raw materials and similar intermediate goods are all derived demands, i.e., induced by the demand for final goods. In the context of inputoutput models, such distinction is often employed. vii)

Individual and Market Demands

This distinction is often employed by the economist to study the size of the buyers’ demand, individual as well as collective. A market is visited by different consumers, consumer differences depending on factors like income, age, sex etc. They all react differently to the prevailing market price of a commodity. For example, when the price is very high, a low-income buyer may not buy anything, though a high income buyer may buy something. In such a case, we may distinguish between the demand of an individual buyer and that of the market which is the market which is the aggregate of individuals.

You may note that both individual and market demand schedules (and hence curves, when plotted) obey the law of demand. But the purchasing capacity varies between individuals. For example, A is a high income consumer, B is a middle-income consumer and C is in the low-income group. This information is useful for personalized service or target-group-planning as a part of sales strategy formulation. viii) Total Market and Segmented Market Demands This distinction is made mostly on the same lines as above. Different individual buyers together may represent a given market segment; and several market segments together may represent the total market. For example, the Hindustan Machine Tools may compute the demand for its watches in the home and foreign markets separately; and then aggregate them together to estimate the total market demand for its HMT watches. This distinction takes care of different patterns of buying behavior and consumers’ preferences in different segments of the market. Such market segments may be defined in terms of criteria like location, age, sex, income, nationality, and so on x) Company and Industry Demands An industry is the aggregate of firms (companies). Thus the Company’s demand is similar to an individual demand, whereas the industry’s demand is similar to aggregated total demand. You may examine this distinction from the standpoint of both output and input. For example, you may think of the demand for cement produced by the Cement Corporation of India (i.e., a company’s demand), or the demand for cement produced by all cement manufacturing units including the CCI (i.e., an industry’s demand). Similarly, there may be demand for engineers by a single firm or demand for engineers by the industry as a whole, which is an example of demand for an input. You can appreciate that the determinants of a company’s demand may not always be the same as those of an industry’s. The inter-firm differences with regard to technology, product quality, financial position, market (demand) share, market leadership and competitiveness---- all these are possible explanatory factors. In fact, a clear understanding of the relation between company and industry demands necessitates an understanding of different market structures.

ExercisesState whether True or False1. The demand for management trainees is derived demand. 2. The share market is always subject to speculative demand. 3. Demand for tea is autonomous demand. 4. Shift in a demand curve can be shown on the same demand curve. 5. Demand function is single variate. Quote appropriate examples of1. Seasonal demand : 2. New demand : 3. Close substitutes : 4. Perfect compliments : 5. Segmented market demand : For the following products what can be the factors (other than its price) which can affect the demand. 1. Umbrella 2. Kids wears 3. Text books 4. Mobiles 5. Tractors How is consumption different from demand?

Case Study Read the following article and state the factors responsible for the demand of Indian skilled labour abroad. Why the west wants desi pros ECONOMICTIMES.COM [ MONDAY, APRIL 26, 2004 12:55:43 AM ] If you are Indian and highly skilled in the specialised professions like IT and medicine then countries like the US, the UK and the rest of Europe are desperately on the look out for you. And why not? You bring much needed talent in sparsely supplied fields and high-end jobs also mean more money through taxes for the host countries. Till recently, you had to be either a high-powered banker or an MNC executive if you were to make it to the rich countries. Now not only are Indians, engaged in new economy sectors, moving abroad but jobs are also moving to India The US and the UK have created special immigration schemes to attract Indians, apart from improvising on existing schemes that have existed for some years in Australia, Canada, and New Zealand. Germany, meanwhile, has brought about a new "green card" scheme to recruit foreign IT specialists and to train 2,50,000 domestic specialists by 2005. As is well-known, the Silicon Valley is much dependent on Indians for supplying entrepreneurs as well as workers. The new approach centres around the governments’ working in close quarters with employers to cut down on labour shortages. The recruitments are highly tailored to meet specific requirements by industry and then to fasttrack admissions on a temporary basis.

While much ink has been spilled over the rising trend of Indian professionals snatching away the jobs from their American and European counterparts in their country, nobody doubts that the skilled, English speaking, hardworking, tech-savvy, and of course much economical Indian professionals deserve them. Therefore, is it any surprise that more and more Indian professionals are now packing their bags and heading towards newer foreign destinations than the traditional US-UK-West Asia to fulfil their career goals. However, this

should not ring alarm bells for countries like the US, UK and Canada, which already have huge Indian populations. Primarily, because this flight is one that is tremendously beneficial to the host country as it gets to benefit greatly from the presence of skilled Indian workers. More and more Indian doctors, nurses, teachers and software professionals wanting to migrate, mean big revenues in the form of taxes and services. Further, they also add to the country’s knowledge bank and help boost the skill base. Although most developed nations like the UK and Australia remain apprehensive about employing the services of highly skilled overseas workers, analysts suggest that in the long-term, such migrations will benefit these countries more than it harms them. According to Harvard Professor Jorge Borjas the benefit from the highly-skilled immigrants to the US economy are greater than the short term concern of losing jobs. An immigrant with below-average education will cost the US about $13,000 per year whereas one with at least two years of college education generates $198,000 in taxes over his lifetime. The past decade has witnessed the entire world inching closer under the fold of globalisation. Countries have come closer and mutual inter-dependence in terms of trade and commerce have taken a huge northward leap. Therefore it comes as no surprise that the IT industry, especially in the Silicon Valley, is effectively manned by Indian software engineers.

Slide 1

Meaning of Demand Demand means effective desire Effective desire=desire+willingness to pay + ability to pay Without willingness and ability to pay desire can’t be effective demand

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Slide 2

Types of Demand Direct and derived demand Domestic and industrial demand Autonomous and induced demand Perishable and durable goods demand New and replacement demand Final and Intermediate demand 7. Individual and market demand 8. Short run and long run demand 1. 2. 3. 4. 5. 6.

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Slide 3

Factors determining demand Price of the product Price of related goods Income of the consumers Tastes preferences of the consumer Availability of the goods Advertisement for the product Price expectation of the user Other factors

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Slide 4

Demand schedule It’s a tabular representation of the price and the quantity demanded. It tells us the relation between the price of the product and the quantity demanded

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Slide 5

Types of demand schedule Two types of demand schedule 1. Individual demand schedule 2. Market demand schedule

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Slide 6

why demand curve slopes downward Inverse relationship between price and the quantity demanded Substitution effect

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Slide 7

Change in demand Change in demand means increase or decrease in the demand due to factors other than price of the product

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Slide 8

Reasons for changes in demand Changes in number of consumers Changes in the income and wealth of the consumer Changes in consumer tastes and preferences Expectation of changes in price Changes in the price of substitute Changes in the price of complementary goods

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Slide 9

Changes in quantity demanded It is based on the assumption of the law of demand Changes in quantity demanded due to changes in the price of the products.

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